A bit more on the FSOC’s Volcker Rule study (pdf). The FSOC makes a number of recommendations for designing an enforcement mechanism for the Volcker Rule — some better than others.

As an initial matter, the FSOC recommends that banks be required to give regulators certain information about each trading desk, most importantly:

- a listing of the types of products approved for transactions;
- a description of how positions are hedged; and
- a description of the activity typical of the customer base.

While I think this is a good idea, and it’s important for regulators to have this information, I wouldn’t focus too heavily on deviations from normal trading practices/procedures. If a bank wants to build up a proprietary position in equities, it’s not going to do it from the MBS desk; it’s going to do it from an equities desk. So there likely won’t be a deviation from the types of products used on the desk. And in fact, sometimes trading desks do actually use products for which they’re normally not approved as part of legitimate hedging strategies. For example, a fixed-income desk trying to hedge its largest counterparty exposure may have to resort to buying puts if, say, they can’t buy enough CDS protection to cover the counterparty exposure (or if they can’t get one of the bank’s super-sweet in-house lawyers to scare the counterparty into politely negotiate a better CSA).

More promising are the quantitative metrics. As I’ve noted before, “there are signals which are indicative of proprietary trades, and market-making trades can be distinguished from proprietary trades by looking at those signals.” The FSOC study proposes a surprisingly broad array of quantitative metrics, which I think is encouraging. If I was designing the Volcker Rule enforcement regime (which, thankfully for all of us, I am not), I would focus less on the risk-based quantitative metrics, and more on the inventory and customer-flow metrics.

The most straightforward — and, incidentally, most effective — metric will be “inventory turnover,” which the FSOC study discusses on pp. 39–40. For liquid instruments, inventory turnover should be relatively predictable over time, and if a trader decides to build up a proprietary position, it should usually show up as a deviation from the normal inventory turnover rate for that desk. Of course, it may be difficult for regulators to establish an accurate baseline inventory turnover rate, seeing as most market-making desks already operate with some level of proprietary overlay. I don’t have a good way for regulators to ensure that their initial baseline inventory turnover rates are accurate, unfortunately. (Or, at least, I haven’t thought of one yet. Don’t worry though — despite what they may think, traders aren’t that clever.)

Customer-flow metrics will also be reasonably effective in distinguishing proprietary trades from market-making trades. As the FSOC study notes:

These metrics evaluate the volume of customer-initiated orders on a market making desk against those orders that are initiated by a trader for the purposes of building inventory or hedging. Significant trader-initiated, rather than customer-initiated, order volume could indicate that impermissible proprietary activity has occurred.

“Customer-initiated flow to inventory,” which measures the volume of a desk’s inventory relative to the desk’s average customer-initiated trades, can be particularly revealing. The average volume of customer-initiated trades can provide regulators with a rough measure of how big an inventory the desk should be carrying, and a noticeable swelling of a desk’s inventory can be indicative of proprietary activity.

In any event, those are the metrics that I would focus on if I was designing the Volcker Rule enforcement regulations.

One of the most important issues in the derivatives title of Dodd-Frank is who qualifies as a “major swap participant” (MSP). These are supposed to be entities that aren’t swap dealers, but are still big enough players in the swap markets that their failure could cause serious problems. In other words, the major buy-side players (AIG, Blackrock, etc.). The reason this is so important is that MSPs are subject to much more stringent regulation by the CFTC, including — significantly — capital and margin requirements.

The CFTC has now published a proposed rule (pdf) defining “major swap participant,” and it’s safe to say that I’m not a fan. It’s a mess: not well drafted, and way too easy to evade (i.e., underinclusive). Or, I should say, it’s probably too easy to evade — it’s not entirely clear, due to the serious drafting issues. I know this isn’t a very sexy issue, but this is the important stuff, so bear with me.

Dodd-Frank creates three tests for determining whether an entity qualifies as a MSP, though only the first two are important for our purposes. The first test states that a MSP is anyone who isn’t a swap dealer and who:

(i) “maintains a substantial position in swaps for any of the major swap categories,” excluding “positions held for hedging or mitigating commercial risk” and certain employee benefit plans.

The second test states that a MSP is anyone who isn’t a swap dealer and:

(ii) “whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets.”

1. “Substantial Position” Test

The CFTC’s first task, which I think they did reasonably well, was to determine what constitutes a “substantial position in swaps for any of the major swap categories.” To do this, they created two “substantial position” thresholds. The first threshold is based on an entity’s current uncollateralized exposure, and the CFTC’s proposed rule sets the threshold at a daily average of $1bn for credit, equity, or commodity swaps, and $3bn for rate swaps. The second, broader, threshold is based on an entity’s potential future exposure, and is set at a daily average of $2bn for credit, equity, or commodity swaps, and $6bn for rate swaps.

This part is largely fine. Current uncollateralized exposure is, intuitively, a good measure of the risk that an entity poses to the broader market, and creating a second, broader threshold as a fail-safe is probably a prudent move. I would, however, object to the CFTC’s decision to rely on “industry practices” for the valuation of posted collateral. Those standards aren’t exactly rigorous, even now, and would be ripe for abuse.

Where the wheels really start to come off the wagon is in the CFTC’s definition of “positions held for hedging or mitigating commercial risk” — which, remember, are excluded from the “substantial position” calculations. Ideally, this term should be defined as narrowly as possible, because current uncollateralized exposure is already a good measure for whether an entity poses a systemic risk.

Unfortunately, the CFTC defines this term by first creating a cartoonishly broad list of transactions that are included in the definition, and then creating an almost-as-broad (but horribly drafted) list of transactions that are excluded from the definition of “hedging or mitigating commercial risk.” For example, the list of transactions that qualify as “hedging or mitigating commercial risk” includes any transaction that is “economically appropriate to the reduction of risks” arising from:

(A) The potential change in the value of assets that a person owns ... or reasonably anticipates owning ... in the ordinary course of business of the enterprise;

(B) The potential change in the value of liabilities that a person has incurred or reasonably anticipates incurring in the ordinary course of business of the enterprise;
...
(F) Any fluctuation in interest, currency, or foreign exchange rate exposures arising from a person’s current or anticipated assets or liabilities.

That describes virtually every single swap that has ever been written — and that’s only part of the list! Then comes the list of transactions that are excluded from the definition of “hedging or mitigating commercial risk,” which is defined as transactions that are:

(i) Not held for a purpose that is in the nature of speculation, investing or trading; [AND or OR? It doesn't say]

(ii) Not held to hedge or mitigate the risk of another swap or securities-based swap position, unless that other position itself is held for the purpose of hedging or mitigating commercial risk.

Gee, it’s a good thing that “held for a purpose that is in the nature of speculation, investing or trading” isn’t broad or ambiguous at all... But seriously, while this phrase is clearly intended to be broad, in order to counteract the cartoonishly broad list of included transactions, I think it’s highly likely that, due to the way it’s drafted, it will only end up encompassing a relatively narrow band of trades that are obviously speculative. Any swaps that an entity can claim are being held for the “purpose” of hedging non-swaps — which would pretty clearly distinguish them from swaps held for the “purpose” trading — will likely fall outside this definition.

Since swaps are frequently used to hedge fixed-income instruments, as opposed to hedging other swaps, the end result is that a large class of swaps will be able to claim the “hedging or mitigating commercial risk” exemption — and will thus be excluded from the “substantial position” calculation.

In short, the CFTC’s “substantial position” test creates enormous ambiguities, and will likely be relatively easy to evade.

2. “Substantial Counterparty Exposure” Test

The “substantial counterparty exposure” test is supposed to make up for this, by calculating current uncollateralized exposure and potential future exposure without any exclusion for “hedging or mitigating commercial risk.” (Or, at least, that’s how the CFTC explains it in the Federal Register.) The first problem is that, based on the language of the proposed rule, it doesn’t do what it’s intended to do. The rule states:

(2) Calculation methodology. For these purposes, the terms “daily average aggregate uncollateralized outward exposure” and “daily average aggregate potential outward exposure” have the same meaning as in § 1.3(sss) [the “substantial position” test], except that these amounts shall be calculated by reference to all of the person’s swap positions, rather than by reference to a specific major swap category.

Well, if the terms have the same meaning as they do in § 1.3(sss), which is the provision establishing the “substantial position” test, then they do still include the exemption for hedging/mitigating commercial risk. Section 1.3(sss) states that “the term ‘substantial position’ means swap positions, other than positions that are excluded from consideration, that equal or exceed [the two] thresholds.” The rule needs to explicitly state that it doesn’t include the exemption for hedging/mitigating commercial risk. As it stands right now, the hedging/mitigating commercial risk exemption is still included the “substantial counterparty exposure” test — making it just as useless as the “substantial position” test.

The second problem is that the “substantial counterparty exposure” test raises the thresholds for current uncollateralized exposure and potential future exposure to $5bn and $8bn, respectively. That strikes me as clearly too high. I mean, $5bn in current uncollateralized exposure isn’t exactly chump change, especially when you consider that we’re only talking about an entity’s swap book. Any entity that has $5bn in current uncollateralized exposure just in its swap is likely going to have significant uncollateralized exposure in other products too. I realize that the statute only refers to swaps, but the CFTC can get around this by simply adjusting the threshold down.

***

Incidentally, the SEC published a nearly identical proposed rule for “major security-based swap participants.” However, the SEC’s rule appears to be much cleaner and tighter than the CFTC’s rule.

I certainly understand that the CFTC has an absurd amount on their plate right now, and still doesn’t have adequate funding, so I think drafting issues like the ones in this proposed rule are entirely understandable. But hey, someone has to pick the proposed rules apart, and it might as well be me.

As I expected, the FSOC’s Volcker Rule study (pdf) doesn’t provide a ton of guidance on the key issues, which are the definitions. It does provide some clues though. I don’t have a ton of time, but here’s what I think are some of the key takeaways:

1. Market-making troubles: Regulators are clearly having trouble figuring out how to define “market-making” for less liquid markets such as swaps. Just look at how vague the “indicia of market-making” they identify for less liquid markets are (on page 29). For instance, they identify “Holding oneself out as willing and available to provide liquidity on both sides of the market” as indicative of market-making. Um, ya think?

2. Inventory accumulation will be a problem: The fact that the statute explicitly permits the accumulation of inventory in anticipation of “reasonably expected near term demands of clients” is going to be a serious problem. The study doesn’t include any ideas for how to place meaningful limits on that exemption.

3. Risk-mitigating hedging activity: The FSOC did actually offer some specifics on how they think regulators should define “risk-mitigating hedging activities.” From page 30 of the study:

Risk-mitigating hedging is defined by two essential characteristics: (i) the hedge is tied to a specific risk exposure, and (ii) there is a documented correlation between the hedging instrument and the exposure it is meant to hedge with a reasonable level of hedge effectiveness at the time the hedge is put in place.

The second prong has the potential to be a major flashpoint. If regulators insist that the effectiveness and proper correlations of hedges that fall under this exemption be rigorously documented, then I could see some real wars breaking out between the banks and regulators over whether a given trade is a legitimate hedge. That would be interesting.

4. Do members of the FSOC read my blog? Maybe. (Probably not.) In an earlier post on the Volcker Rule, I noted that the definition of “trading account” in the statute is very similar to the language used in accounting standards, and I wrote that, as a result,

it’s possible that banks could put on prop trades outside of a “trading account” as long as they agree to use a different accounting treatment for the prop trades. And what if accounting standards change? What if FAS 115 is overhauled in the future? What happens to the definition of “trading account” then?

Also, are we talking about the account where the trade originated? What if a trade is originated in the “banking book,” and then subsequently transferred to the trading book? Since the banking book is (obviously) not a “trading account,” it’s not clear if the trade is still prohibited.

Now look at what the FSOC study recommends with regard to the “trading account” issue: (emphasis mine)

To the extent that Agencies choose to incorporate some type of accounting or similar term in defining “trading account,” the Council recommends that Agencies carefully consider how they might ensure that the prohibition on proprietary trading cannot be avoided through changes in accounting designations (e.g., by designating a position as “available for sale” rather than “trading”). Additionally, if accounting standards are used as the basis for the definition of “trading account” for purposes of the Volcker Rule, it is important that Agencies monitor changes to those accounting standards. (pg. 25)

Yep, that’s close enough for me. I’m going to go ahead and assume that the FSOC made those recommendations after reading my post.

You shouldn’t expect too much from the Volcker Rule study that the Financial Stability Oversight Council (FSOC) is releasing today. It almost certainly won’t get into the weeds of the definitions, which is where all the action in the Volcker Rule fight will be. It may make recommendations on how specific/broad different definitions should be, but that still won’t tell us much.

It all depends on the specific language of the definitions. Instead, the study will likely focus on how regulators should enforce the Volcker Rule. Regulators have already floated the idea of using a three-tiered system, in which certain trades or combinations of trades would set off “tripwires” that automatically alert regulators. This could conceivably work, but again, it all depends on the specific language of the tripwires — if the tripwires are too narrowly defined, for example, they might not catch some proprietary trades.

The WSJ says that the FSOC is “leaning against suggesting precise rules for specific assets or trades, and instead might focus on the amount of risk being carried by a firm or trading desk, according to people briefed on the negotiations.” The WSJ also says that the FSOC will recommend that regulators monitor the size banks’ positions, how long positions are being held, and Sharpe Ratios.

That all sounds reasonable enough — indeed, I’ve suggested monitoring how long positions are being held myself. Regulators were always going to have to use some sort of “tripwire” system to enforce the Volcker Rule, seeing as it’s not even remotely possible (or physically possible, for that matter) for regulators to review every single trade. The FSOC study will probably just confirm that regulators are planning to use a multi-level tripwire system, and provide a better sense of the factors regulators are planning to focus on.

That still won’t tell us much about how effective the Volcker Rule will ultimately be though, because the key is how regulators design this tripwire system. Most importantly, how broad are the categories of trades that set off the tripwires? What actions do regulators take when a tripwire is set off? How often/actively do regulators perform spot checks? What is the punishment for violating the Volcker Rule?

Again, it’s impossible to answer these questions without the all-important definitions. If the definitions of “market-making-related activities,” “risk-mitigating hedging activities,” and “trading account” are too broad, then banks probably won’t have any trouble avoiding the tripwires. If the definitions are sufficiently narrow, and somehow don’t provide banks with multiple opportunities for evasion, then a multi-level tripwire system could very well work. (Given the way the statute was drafted, I fully expect that the definitions will be too broad; don’t say I didn’t warnyou.)

We just don’t know how effective it will be without the definitions. And we likely still won’t know how effective the Volcker Rule will be even after the FSOC releases its study.

(Of course, that won't stop the pundits from claiming that the study proves that regulators have sold out to Wall Street, proclaiming that the Volcker Rule is now officially dead, and somehow managing to blame it all on Tim Geithner. Count on it.)

Peter Schroeder of The Hillpoints out that “Treasury Secretary Timothy Geithner has fended off repeated calls for his resignation to become the last man standing from President Obama’s original economic team.”

To which I say, “hurrah!” I held Geithner in high regard before the crisis, and I think his performance as Treasury Secretary has been superb. He has consistently refused to allow the media/political circus to dictate his policy decisions, and, as a result, has been the target of a seemingly never-ending stream of ill-informed and often disingenuous attacks from journalists, politicians, and pundits. (I’ve head all the criticisms of Geithner, and I’ve found them wanting, to say the least.) But, thankfully, he has endured, and I’d say it’s now likely that Geithner will be Treasury Secretary for the duration of Obama’s presidency. In other words: Geithner wins, pundits lose.

About Me

I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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